The $1 Trillion Liability Stalking Some European Bond Investors

  • New directive on insolvent banks comes into force on Jan. 1
  • Senior bondholders will be on the hook for losses on loans

Another year, another thing for investors in Europe to worry about.

The Bank Recovery and Resolution Directive, part of the regulatory changes since the 2008 financial crisis, comes fully into force on Jan. 1. Insolvent banks will need to be “resolved” rather than liquidated like failed companies, and the cost is supposed to be borne by investors and not taxpayers. Among the new tools is the ability to write down the value of senior bonds or convert them into equity to help bring a failed lender back to life.

The directive is focusing attention on the toxic assets of banks. There were about 1 trillion euros ($1.09 trillion) of non-performing loans at banks in European Union countries as of the end of 2014, equivalent to more than 9 percent of the bloc’s gross domestic product, according to a study by the International Monetary Fund

“The longer bad loans stay on the balance sheet, the higher the probability that investors have to pay for them,” said Daniel Sarp, a London-based fixed-income manager and a member of the bail-in working group of the International Capital Market Association. “The scenario can get quite scary.”

ECB Shield

For the moment, the European Central Bank’s bond-buying program, known as quantitative easing, is masking risks by depressing yields on fixed income across the board.

“The risk of bail-in hasn’t been been priced into the bank senior market,” said Paul Smillie, a Singapore-based analyst at Columbia Threadneedle, which manages about $411 billion globally. “Bank senior debt is just another layer of loss-absorbing capital and I don’t think you’re being adequately rewarded for being an investor.”

Bank senior bonds in euros currently yield 0.83 percent. That compares with an average of 3.64 percent in the five years through Jan. 1, 2007, according to Bank of America Merrill Lynch index data, a period when the notes were protected from losses and untouchable outside of bankruptcy court.

Bank senior bonds in euros, yields
Bank senior bonds in euros, yields

The bad-loan situation is worse in countries hit harder by Europe’s debt crisis. In Italy, almost 18 percent of the total loan book, or 12 percent of 2014 GDP, is delinquent in some way, of which about half is provisioned for, according to the IMF. In Cyprus, whose banking crisis led to losses for depositors, almost 50 percent of the loan book has soured.

Passing the Buck?

The concern about the possibility of losing money is an intended consequence of the new legislation. The idea is that investment managers will help keep better control of banks because they now have more to lose.

Yet that doesn’t make a lot of sense in the real world, according to Gregory Turnbull Schwartz, a fixed-income manager at Kames Capital in Edinburgh. He argues that regulators already have access to information investors can only dream of.

“Regulators are trying to pass the buck,” he said. “They’ve created whole new classes of debt to impose discipline on management, which is absurd. We can sell, true, but is a management team going to take any notice just because their spreads drift a few basis points wider? That’s just silly.”

Implementation, which has to be done by individual jurisdictions, isn’t straightforward, either, because it involves assigning different levels of seniority to liabilities to ensure that losses for bondholders don’t then lead to losses for depositors.

Investors are taking issue with the way some countries are doing that. Germany and Italy are changing laws so that senior bondholders can be bailed in should a lender collapse.

The German law is “pretty much unfair, because it’s retroactive,” said Dan Lustig, who helps oversee about $1.15 trillion as an analyst at Legal & General Investment Management in London. “That’s one of our biggest concerns. You shouldn’t change the terms and conditions on debt after investors bought it.”

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